Component Method Focus

For measuring and monitoring of IRRBB, institutions should use at least one earnings-based measure and at least one economic value measurement method that, in combination, capture all components of IRRBB. Large institutions with cross-border activities, in particular institutions under categories 1 and 2 of the SREP Guidelines, and institutions with complex or sophisticated business models, should use multiple measurement methods, as further specified in Annex II.

4.4.3 Interest rate shock scenarios for ongoing management

Institutions should regularly, at least quarterly and more frequently in times of increased interest rate volatility or increased IRRBB levels, measure their exposure to IRRBB in terms of changes in economic value and earnings under various interest rate shock scenarios for potential changes in the level and shape of the interest rate yield curves, and to changes in the relationship between different interest rates (i.e. basis risk).

Institutions should also consider whether to apply a conditional or unconditional cash flow modelling approach. Larger and more complex institutions, in particular institutions under categories 1 and 2 of the SREP Guidelines, should also take into account scenarios where different interest rate paths are computed and where some of the assumptions (e.g. relating to behaviour, contribution to risk, and balance sheet size and composition) are themselves functions of changing interest rate levels.

Institutions should assess exposures in each currency in which they have positions. For the material currency exposures, the interest rate shock scenarios should be currency-specific and consistent with the underlying economic characteristics. Institutions should include in their internal measurement systems methods to aggregate their IRRBB across different currencies. Where institutions make use of assumptions about dependencies between interest rates in different currencies, they should have the necessary level of skills and sophistication to do so. Institutions should take into account the impact of assumptions regarding dependencies between interest rates across different currencies.

When selecting interest rate shock scenarios, institutions should consider the following:

• (a) That their own internally developed interest rate shock scenarios be commensurate with the nature, scale and complexity of their activities as well as their risk profile, taking into account sudden and gradual parallel and non-parallel shifts and changes in the yield curves. Scenarios should be based on the historical movements and behaviour of interest rates, as well as simulations of future interest rates.
• (b) Interest rate scenarios that reflect changes in the relationships between key market rates in order to address basis risk.
• (c) The six prescribed interest rate shock scenarios set out in Annex III.
• (d) Any additional interest rate shock scenarios required by supervisors.

In low interest rate environments, institutions should also consider negative interest rate scenarios and the possibility of asymmetrical effects of negative interest rates on their interest rate sensitive instruments.

The results of shock scenarios should feed into the decision-making at appropriate management level. This includes strategic or business decisions, the allocation of internal capital, and risk management decisions by the management body or its delegates. The results should also be considered when establishing and reviewing the policies and limits for IRRBB. 4.4.4 Interest rate stress scenarios

IRRBB stress testing should be considered in the ICAAP, where institutions should undertake rigorous, forward-looking stress testing that identifies the potential adverse consequences of severe changes in market conditions on their capital or earnings, including through changes in the behaviour of their customer base. Stress testing for IRRBB should be integrated into institutions’ overall stress-testing framework, including reverse stress testing, and should be commensurate with their nature, size and complexity, as well as their business activities and overall risk profile.

IRRBB stress testing should be performed regularly, at least annually and more frequently in times of increased interest rate volatility and increased IRRBB levels.

The IRRBB stress-testing framework should include clearly defined objectives, scenarios tailored to the institution’s businesses and risks, well-documented assumptions and sound methodologies.

In enterprise-wide stress tests, the interaction of IRRBB with other risk categories (e.g. credit risk, liquidity risk, market risks), and any material second-round effects, should be computed.

Institutions should perform reverse stress tests in order to (i) identify interest rate scenarios that could severely threaten an institution’s capital and earnings; and (ii) reveal vulnerabilities arising from its hedging strategies and the potential behavioural reactions of its customers.

In testing vulnerabilities under stressed conditions, institutions should use larger and more extreme shifts and changes in interest rates than those used for the purpose of ongoing management, including at least the following:

• a) substantial changes in the relationships between key market rates (basis risk);
• b) sudden and substantial shifts in the yield curve (both parallel and non-parallel);
• c) breakdowns of key assumptions about the behaviour of asset and liability classes;
• d) changes in key interest rate correlation assumptions;
• e) significant changes to current market and macro conditions and to the competitive and economic environment, and their possible development; and
• f) specific scenarios that relate to the individual business model and profile of the institution.

The results of stress scenarios should feed into the decision-making at the appropriate management level. This includes strategic or business decisions, the allocation of internal capital, and risk management decisions by the management body or its delegates. The results should also be considered when establishing and reviewing the policies and limits for IRRBB.

4.4.5 Measurement assumptions

When measuring IRRBB, institutions should fully understand and document key behavioural and modelling assumptions. These assumptions should be aligned with business strategies and be regularly tested.

Institutions should, in relation to both economic value and earnings-based measures of IRRBB, take into account assumptions made for the purpose of risk quantification in relation to at least the following areas:

• a) the exercise of interest rate options (automatic or behavioural) by both the institution and its customer under specific interest shock and stress scenarios;
• b) the treatment of balances and interest flows arising from NMDs;
• c) the treatment of fixed term deposits with risk of early redemption;
• d) the treatment of fixed rate loans and fixed rate loan commitments;
• e) the treatment of own equity in internal economic value measures;
• f) the implications of accounting practices for the measurement of IRRBB, and in particular hedge-accounting effectiveness.

As market conditions, competitive environments and strategies change over time, institutions should review significant measurement assumptions at least annually, and more frequently during rapidly changing market conditions.